Despite Fears, Mutual Funds Wade Into ETFs

If much of human nature comes down to a struggle between greed and fear, then the mutual fund industry is proving itself very human, at least in regards to creating exchange-traded funds.

First, the greed. Cash flows into ETFs continue to outpace cash flows into mutual funds-ironically, ETFs have gained more than $500 billion in assets over the past five years, while mutual funds have lost almost the same amount during that time-leaving mutual fund companies like Fidelity, Vanguard and Pimco eager to find ways to bring that money back to their funds, according to data from Strategic Insight.

"The big mutual fund companies are seeing the inflows into the ETF market and wanting to capture some of that," said is Dan Weiskopf, a co-portfolio manager at Forefront Capital, a money management firm with about $121 million in assets under management. "And you're starting to see the big gorillas move into this area-it's the idea of cannibalizing your own product, or sitting back and watching somebody else do it."

This is where the fear comes in, said Garrett Stevens, president and chief executive of Exchange Traded Concepts, an Edmond, Okla.-based advisory firm for those wanting to create their own ETFs. Stevens said his firm increasingly been having conversations with small- and mid-tier mutual funds companies that want to break into the $1.2 trillion ETF business.

However, the biggest impediment his mutual fund clients face in creating their own ETFs is the requirement for ETFs to give investors daily portfolio disclosure.

"That is the biggest sticking-point," he explained. "Most mutual funds and even hedge funds desperately want to create ETF versions of their flagship funds, but do not want to be compelled to disclose their holdings on a daily basis."

While less of a hurdle for index or bond ETFs, the disclosure rule can act as a deal-killer if the mutual fund the ETF seeks to mimic is an actively managed equity fund.

Disclosure of the ETF's daily stock buying and selling would allow investors to simply bypass the fund altogether and set up their own stock portfolio, raising the fear among fund companies that venturing into ETFs could indirectly lead to the cannibalization of their mutual fund products.

There are many strategies to avoid this, Stevens said, and one way around it is to create a "lite" ETF version of the flagship fund, which would mimic most, but not all, of the flagship fund's portfolio.

Or, a fund company could create an ETF that would represent a single component of the flagship fund, such as its investments in a certain sector or security type.

"So it's like investors would be getting most of the fund's secrets, but not all," Stevens said.

Other large mutual fund companies like Vanguard and Pimco are making strategic moves into the ETF area, but are being very careful not to give investors a reason to abandon the funds that the ETFs may be based on.

Most notably, Pimco created the Pimco Total Return ETF (BOND) in March, mimicking its flagship $270 billion Pimco Total Return bond mutual fund. The ETF, which already has amassed assets of $2 billion, closely follows the strategies of the mutual fund, and Pimco co-chief investment officer Bill Gross manages both the fund and ETF.

Since its inception, BOND is outperforming the mutual fund it's based on, returning 8.1% in total return on net asset value through the end of July, compared to a 4.6% return on the institutional shares of the mutual fund for the same period.

Encouraged by BOND's positive results, Pimco reportedly is planning to roll out ETF siblings of its other famous funds, like the Pimco Real Return fund and the Pimco Diversified Income fund. A message into Pimco was not returned by press time.

"Pimco did something smart with the BOND ETF," said Geoffrey Bobroff, an independent consultant in the mutual fund industry. By pricing the ETF at a lower price for retail investors compared to the price of the Total Return mutual fund, Pimco greatly cut down on any possibility of cannibalizing the mutual fund product. "But you can't look at one fund, especially a bond fund and say it's going to work every time," he added. "Creating ETFs is not the panacea that many fund companies are imagining."

Vanguard, the mutual fund company that has most embraced the ETF sector, also did it in a unique way to cut down on the possibility of cannibalization. Vanguard establishes ETF versions of its more famous index funds by creating the ETF as a separate class of shares within the fund itself. The patented method has allowed Vanguard to create 64 U.S.-based ETFs with assets of $215 billion since launching its first ETF share class in 2001. The company is also the industry leader in year-to-date cash-flow to their ETFs, with $32 billion coming in the door through the end of July, according to the firm.

The firm expects to introduce a short-term Treasury Inflation-Protected Securities fund and ETF in the fourth quarter, and plans on unveiling two international bond funds/ETFs in 2013, according to spokesman David Hoffman. "Also, we have been busy abroad, announcing a family of ETFs in the United Kingdom in May, and our second series of ETFs in Canada in early September," he said.

Other mutual fund giants, like Fidelity, are less sure of these waters. Fidelity created its first ETF-Fidelity Nasdaq Composite Index Tracking (ONEQ)-eight years ago and never really made ETF development a priority even as the ETF market boomed. Now, that may be changing. Fidelity filed with the Securities and Exchange Commission earlier this year to be allowed to launch actively managed ETFs, sparking speculation that ETF versions of Fidelity's famed sector funds could be forthcoming.

While not confirming that outright, Jeff Cathie, a Fidelity spokesman said the company has made moves in its sector investment unit to facilitate ETF creation if the company chooses to go that way. "We recently established a new division that will focus exclusively on leveraging our current sector investment management expertise and scale to meet the evolving needs of our clients for more specialized sector portfolio investment options," said the spokesman, adding that while Fidelity hasn't yet determined what form this new sector leverage will take, the company has "long recognized that some investors may want to use index funds and ETFs, in addition to actively managed mutual funds, to meet their needs."